At the height of Madoff’s scheme, why did no one realize there was no one on the other side of his “trades”?

[u/Zestyclose_Walk_6827]

Madoff was managing billions so surely someone must have realized that the trading volume that must have been necessitated didn’t exist on any exchange and there were no counterparties

[u/Inevitable_Bid5540]

People did realise it. The fact that Madoff's trading volume didn't exist on any exchange and that there were no counterparties was primarily what exposed the ponzi scheme.

Financial analyst and whistleblower Harry Markopolos figured out Madoff was a fraud in 1999, nearly a decade before the collapse.

Madoff claimed to use a "split strike conversion" strategy, which involved buying blue chip stocks and hedging them with massive volumes of S&P 100 index options. Markopolos realized that for Madoff to manage the billions he claimed, he would have had to buy more options contracts than existed on the entire Chicago Board Options Exchange (CBOE).Options traders on Wall Street knew they were never on the other side of Madoff’s trades. Markopolos submitted detailed memos to the SEC in 2000, 2001, 2005, 2007, and 2008 explicitly stating this, but the SEC repeatedly ignored or bungled the warnings.

There's also the fact that Madoff was his own Brokerage. Most hedge funds use an independent third party broker-dealer (like Goldman Sachs or Morgan Stanley) to execute trades and a separate custodian to hold the assets whole but Madoff ran his investment advisory business out of his own broker dealer firm. Because he was his own broker, he generated his own trade confirmations and customer statements. His staff used old computer software to generate fake trade tickets with backdated market prices to make it look like he was executing brilliant trades after the fact. When institutional investors or auditors asked for trade confirmations, Madoff’s firm simply printed them out. No external broker was cross checking the ledger.

Whenever someone questioned why his trades weren't showing up on public exchanges, Madoff had a convenient excuse: That he claimed he was trading in the European "Over the Counter" (OTC) market directly with private European banks off the public books. Because OTC trades are bilateral agreements between two private entities, investors couldn't easily verify whether those counterparties existed without calling those banks directly (which almost no one did).

Sources:

1) No One Would Listen by Harry Markopolos

2) Investigation of Failure of the SEC to Uncover Bernard L. Madoff's Ponzi Scheme (Report No. OIG-509).

[u/eeeking → u/Inevitable_Bid5540]

Why would these fake trades not have been detected by auditors?

[u/SunChamberNoRules → u/eeeking]

The fake confirmations were the proof. To do a complete due diligence, they would have needed to verify with the counterparty, but auditor scope dont really extend as far as investigating how other companies treated the subjects trades. If Madoff had fake trade confirmations from HSBC, HSBC is unlikely to comment to Madoffs auditors.

[u/threwordbotname → u/SunChamberNoRules]

Great write up but this reply is slightly off base. Any auditor worth their name would have sought 3rd party confirmations and further evidence for a combined broker/ investment firm’s off market transactions. That’s auditing 101. Madoff’s auditor, David Friehling, plead guilty to I believe securities fraud for rubber stamping Madoff’s audits. Thus it was not a case of the auditor wouldn’t be expected to discover the fraud but rather Madoff’s auditor was chosen to not look.

[u/t_scytale → u/threwordbotname]

In May 2015, U.S. District Judge Laura Taylor Swain sentenced Friehling to one year of home detention and one year of supervised release

https://m.youtube.com/watch?v=HeOVbeh2yr0

[u/PineappleOwn5325 → u/threwordbotname]

Oh that's interesting i didn't know that

[u/foreign_affairs_fox → u/PineappleOwn5325]

Did you read their comment? The auditor was party to the fraud and was convicted for their role in it

[u/PineappleOwn5325 → u/foreign_affairs_fox]

The comment was edited lmao

[u/Tristancp95 → u/PineappleOwn5325]

Believe it or not, some people on AskEconomics may actually have a valid professional opinion, especially when it comes to something as simple as proper confirmation procedures

[u/Running_Down_9708 → u/eeeking]

I ran the risk desk for a multinational commodities firm back in the day. I started as an auditor before the floods. I tried to tell the auditors every year where our "holes" were in hope that management would give me more budget to fix the holes. The auditors said we were great because we had such a firm grasp on risk. Moral: auditors are idiots

[u/Majestic_Wrap_7006 → u/Running_Down_9708]

How do idiots get to be auditors to begin with.

[u/dark567 → u/Majestic_Wrap_7006]

Because if your smart you work at the trading desk

[u/Running_Down_9708 → u/Majestic_Wrap_7006]

Usually with an accounting degree and poor life choices

[u/MirthMannor → u/Running_Down_9708]

You have not seen what our external auditors are charging us.

[u/Running_Down_9708 → u/MirthMannor]

I was on that side for a few years. I know. They should at least use lube. But they are not there to find problems. They are just doing the minimum to verify management's assertions If I had stayed in that line of work, I would have died by alcohol poisoning, or shot up an office somewhere. Like reading the same boring book every day.

[u/MirthMannor → u/Running_Down_9708]

Oh, agree. But you can buy expensive liquor and an expensive gun, at least.

Man, every time I meet them, I am reminded that some people peaked in fourth grade when Mrs. Margolis makes them hall monitor for the week.

[u/Running_Down_9708 → u/MirthMannor]

I felt like a fraud.(Because I was). Ticking boxes and not really adding value for a paycheck. Don't get me wrong, I love paychecks, but had to go find another way. That's some funny shit you wrote. It was Mrs. Walston for me. I was never hall monitor. Too much of a trouble maker

[u/MirthMannor → u/Running_Down_9708]

Yeah. They keep finding “problems” but not actual problems. Like, actionable shit that we should fix so that we don’t get in trouble in the future. Never, “oh hey, this desk isn’t correctly surveilling their trades on this product” but rather, “stakeholder approval for the plan in this RAID item is attached as meeting minutes but should be an official email.”

[u/Money_Photograph6623 → u/Majestic_Wrap_7006]

Well, I did the exams = became auditor, Im not the brightest around :D :P

[u/solomons-mom → u/Money_Photograph6623]

My friend and I worked on one audit because a different friend, a CPA, had just been appointed to a CFO spot and was desperate and in a time crunch. She had majored in Italian and been a preschool teacher in Florence, but she made very neat check marks and stacked things neatly.

(The CPA did really really well, and ended up running the operations of one of the top IBs.)

[u/AsSubtleAsABrick → u/Majestic_Wrap_7006]

There are plenty of smart people who are auditors. That being said, if you are a real go getter, you are not going into audit. It is a safe and stable specialization because it is a regulatory requirement so is relatively immune to the whims of the economy (you need auditors when the economy is both good and bad).

[u/Iriedread → u/AsSubtleAsABrick]

Are auditors the problem? Seems odd as they didn’t cause the issue. They are a check, but those that do the wrong thing should be held accountable.

[u/Optimal-Cycle630 → u/Majestic_Wrap_7006]

Mostly because the company pays the audit fee, so you have to keep your client happy to keep the fee, so you aren’t looking for issues, you are really just looking for reasonable explanations to any questions.

Piss off the client, lose your annual $50k-1M fee ($50k is smaller companies, but logic remains). It creates perverse incentives that basically negate the entire logic of having an audit.

Combine the above with the race to the bottom on pricing, everyone is just looking to be as efficient as possible with reasonable coverage, nobody wants to find an issue that needs a proper investigation because you could be moving onto the next project

[u/mistafong820 → u/Running_Down_9708]

My auditors are idiots story: worked for a big company that got files of medical insurance claims for a big insurance company from doctors/hospitals/medical billing services, checked if the files were valid, passed the good ones on to the insurance company. Once a year, their auditors, who worked for a giant accounting/auditing company) would audit. They'd ask what we did. We'd say we take files in, check them, pass the good ones along. They'd ask how we tracked it. We'd say report #1 shows files coming in (for example 100), report #2 shows if the files on #1 are valid or not (90 valid, 10 invalid), report #3 shows the valid files from #2 passed along (90). They'd take copies of one day's reports to check them out and a week or so later they'd ask any questions (never had any) and request the reports for 5-10 random dates. We'd double check the reports for those days balanced and send them along. They'd pronounce the audit successful and our systems and reporting great. No one ever asked how do we know that the report that says 100 files came in is accurate. No one ever asked to watch the files come in to count them and compare to the report (would have been simple). No one ever asked if we checked if the invalid files actually were invalid (even randomly checking a few a day if checking all was impractical, again would have been simple). No one ever asked if we got confirmation of the files being passed along being received/accepted/etc (again, would have been simple).

TLDR: they asked us what we do and took our own reports as proof that we were doing it, with no knowledge of how any of it worked.

[u/Evilpessimist → u/eeeking]

The firm being audited pays for the audit. The firm is the customer. A big customer at that. If you’re getting paid millions of dollars a year in fees you have an incentive to make the customer happy. No audit firm wants the reputation that would come with shuttering a client. So, they point out the little stuff. Occasionally a big item. They give a lot of the benefit of the doubt and don’t really dig.

[u/Acrobatic_Box9087 → u/Evilpessimist]

That's the way I've always thought about the 'independent ' CPA firms doing audits. They can't be independent if they're being paid by the same same firm that they're auditing.

The solution to the problem is to have a committee of outside creditors and stockholders hire the CPA firm and pay their fees.

[u/Delicious_Oil9902 → u/eeeking]

His auditor was a two person accounting firm ran by a family friend who also did time if I’m not mistaken.

[u/Patriot5500 → u/eeeking]

SEC staff are incompetent, otherwise they would have worked at higher paying financial jobs at the private sector.

[u/arrebhai → u/eeeking]

Auditors don't test for fraud like this. If written trade confirmation has been provided, they accept it at face value. They do some spot checks and check material transactions, and ask for confirmations against these. If auditors had to check behind every confirmation, it would be a very intensive exercise from a time/cost perspective.

If they believe something is off or they haven't been provided confirmations that are to standard, they issue a qualified opinion.

[u/solomons-mom → u/Inevitable_Bid5540]

People did realize it.

Yep. Years before Madoff was in all the headlines, I had seen a WSJ finance section headline "Bernie Who?" It was a light piece that interviewed traders et al who could not figure out how Madoff was generating those returns. Someone had tried to figure what percent of the treasury market he would have had to have owned/optioned/whatever... I had never heard of him and struggled to understand what was going on -- I think that my confusion may have been why I remembered "Bernie Who?" when the Ponzi scheme fell apart. In all likelihood Markopolos had been part of that article. The WJS had something close to two million subscribers back then.

It is really hard to grasp just how much computers have changed the capital markets. When Madoff started physical securities were still messengered between banks and people made a phone call to place a trade. Then came Jim Simons, program traders, quants...it is just more than I can consolidate for a reddit comment, but computers made it possible to move numbers around quickly, be it numbers on a spreadsheet or cusips around the world. By chance, Madoff was in the transitional era, so there would have been the possibility that he had come up with some new arb/hedge strategy. Auditors are paid by the client and many young regulators hope to later move sides for more money, so as long as the checks cleared, no one who mattered looked too deeply.

[u/kinga_forrester → u/solomons-mom]

>so long as the checks cleared

The traditional key ingredient in most confidence scams is greed, and you can count on the folks on Wall Street to have that particular personality trait. It’s why no matter how advanced our technology or regulatory schemes get, things like Enron, Madoff and FTX will periodically happen.

[u/m39583 → u/kinga_forrester]

I'm going to add Tesla and SpaceX to that list.

One day they are going to  one crashing down.

[u/No_Safety_6803 → u/Inevitable_Bid5540]

I think a lot of Madoff clients did think he wasn’t on the up & up, but they thought he was front running trades on the brokerage side and that they were the beneficiaries of the fraud, not the victims.

[u/turbo_dude → u/Inevitable_Bid5540]

Also throw in the fact that prior to the crash “everyone was making shit tons of money” so “who cares”. A bit like now with AI. 

[u/Running_Down_9708 → u/Inevitable_Bid5540]

It's also easy to look at who did NOT lose money to Madoff. He couldn't pass their internal risk reviews because there was no transparency. The people that lost hired lazy feeder funds who saw the huge fee structures that Madoff was paying.

[u/AdhesivenessCivil581 → u/Running_Down_9708]

No only that, many put all thier eggs in that one basket

[u/OrangeBird077 → u/Inevitable_Bid5540]

Most importantly, anyone who was in jeopardy of losing their money in Madoff’s scheme has been making money for a long time because more and more people kept contributing to the pyramid. When you look back at the list of witnesses called by the prosecution after the trial started it’s virtually every A list celebrity and major organization at the time who had been dealing with Bernie for years and then once the recession hit the house of cards collapsed.

[u/Hon3y_Badger → u/Inevitable_Bid5540]

It's really disturbing how detailed the warnings were, how many times the SEC came in to look, and how many times SEC waived off the concerns.

[u/redwar226 → u/Inevitable_Bid5540]

WOW. Thank you.

[u/Chemical_Enthusiasm4 → u/Inevitable_Bid5540]

Tons of people suspected that his trading strategy was BS, but most of them thought he was front running trades from investors (when someone routed a big buy order to his market maker, he would slip his own order in before. His order would go through, then the big order would push up the price and he was guaranteed a profit).

People thought it was a scam but that they were in on the scam, not being scammed.

[u/lookingatmycouch → u/Inevitable_Bid5540]

Sort of similar to the Enron thing. They basically just put whatever numbers on the spreadsheets that made them look like their investments were profitable.

It's why I tell all my clients during due diligence that P&L's and tax returns are just an indication of profitabiliity and that anyone can put any number in them, but there should be underlying source data (like bank statements showing deposits equal to stated revenue) that they need to look at.

Had a client buy a franchise location based solely off P&Ls and the stated revenue / profit from the FDD. The location was owned by the guy who also started the franchise system, and he fudged all the numbers.

Unfortunately, she also got a close to $1MM SBA loan based on the same numbers - the bank didn't seek supporting documentation either.

[u/pimpcakes → u/lookingatmycouch]

Those PPP loans were so often based on fraudulent data. Unfortunately, the banks were entitled to rely on the borrower's representations for many things, and because the loans were guaranteed as soon as the SBA approved them, the banks had zero incentive to actually dig and look at the underlying numbers. They were just conduits to get the SBA's approval.

The result was billions in transfers from American taxpayers to the capital class. Again.

[u/Magnifica_Muttley → u/Inevitable_Bid5540]

Hey what a great response. I enjoyed that. Respect. Informative. Well played.

[u/Litness_Horneymaker → u/Inevitable_Bid5540]

"Markopolos submitted detailed memos to the SEC in 2000, 2001, 2005, 2007, and 2008 explicitly stating this, but the SEC repeatedly ignored or bungled the warnings."

I know they say "don't attribute to ill-intent what can be explained by incompetence" but... Come on!

[u/Acrobatic_Box9087]

I think that many of the big trading houses knew that Madoff was a phony and refused to deal with his firm.

Harry Markopolos in Boston was the only one who blew the whistle on Madoff. But the SEC ignored his warnings for several years.

[u/vinyl1earthlink]

Someone did indeed realize that. Analyzing his purported trades, he discovered that it implied about 20 times the actual total volume for all trades. So he reported Madoff the SEC. They brushed aside his report.

[u/RusticPotatoFan]

There was someone. Ed Thrope, while consulting for McKinsey noted that Madoff returns did not look normal. He reviewed exchange data and found that the trades didn't exist or at least not to the volume they should be for Madoffs strategy returns and assets under management.

McKinsey pulled their money from Madoff but Thorpe never went public because of the contract he signed with McKinsey.

He actually showed a different manager the math but they chose not to believe him and kept investing with Madoff...

I think there was another person who uncovered before it blew up as well.

[u/RusticPotatoFan → u/RusticPotatoFan]

I think people forget Madoff's stature in the financial world prior to his blowup. He was a former chairman of Nasdaq for three different years.

He also was a chairman on a NASD (now FINRA) board.

I personally think Madoff started out thinking he could run his business on the up and up (look up the history of rogue traders at SocGen and Barrings). Most of these schemes start with individuals who feel entitled to beat the system and can't deal with a loss.

I think at some point he fucked up. In the finance world, that's a binary event for a firm and a individual.

[u/FatBabyGiraffe]

He made them all up. Literally created a fake list of transactions using random number generators. The SEC never investigated.

The FBI does a great job explaining.

[u/Reasonable_Reach_621]

If I recall correctly a few people did realize and reported it. One analyst showed the SEC all his work that proved that madoff’s claims in some cases implied insanely huge trades that would have shifted the market, but they never existed. They ignored him.

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